Kinder Morgan Partners (NYSE:KMP) has dropped its plans to construct the Freedom pipeline that would have carried crude oil from the Permian basin in Texas to California, as many potential shippers have opted to use railroads over the pipeline. The 277,000 barrel per day pipeline was first proposed in April and was projected to cost around $2 billion to build. KMP began the “open season” process, which is used to gauge market interest for oil and gas projects before construction, but the response from some of the largest refiners in California including Tesoro (NYSE:TSO) and Valero Energy (NYSE:VLO) was quite lackluster, prompting the company to cancel the project.
Railroads Offer Shippers Better Flexibility
Pipelines still dominate the energy shipment landscape in the United States, carrying almost two-thirds of all petroleum transported in the country.  Pipelines are generally more cost effective, efficient and are also viewed as a safer means of carrying oil. However, they offer a lot less flexibility since midstream energy companies typically require shippers to sign long term contracts for using pipelines.
KMP had proposed a fee of around $5 per barrel for shipping crude from Texas to California. In comparison, transporting crude via rail from producers in North Dakota to California costs around $12 per barrel.  Since crude from North Dakota is actually cheaper, the landed cost for refiners in California works out to be almost the same even after factoring in the higher rail transportation costs. Additionally the advantage of not having to sign long term contracts is likely to have tipped the scale in favor of rail transportation.
Given the dynamics of the energy market and the varying crude oil prices between various producing basins means that using railroads would allow refiners to source from different regions depending on the prices rather than be locked into pipeline contracts that are specific to a certain geography. This flexibility is even more important for refiners in California, since they incur among the highest operating costs because environmental norms are stricter in the state.
KMP Is Also Eyeing Crude-By-Rail Projects
While crude-by-rail was typically seen as a stop-gap means of transportation, used when pipelines were not available, shipment demand has soared in recent times. Between 2011 and 2012, volumes of crude oil transported by railroads grew by over 250%.  Additionally, the increasing oil production in the U.S. and the added flexibility of railroads are likely to boost interest further going forward. KMP has also been looking towards the crude-by-rail space as a way to diversify its business. In February, the company outlined plans to construct a 210,000 barrels per day crude-by-rail terminal in Houston through one of its subsidiaries. (Business Wire) The company is also expected to focus on more crude-by-rail projects in Texas and California going forward.
We have a $89 price estimate for KMP which is around 7% ahead of the current market price.
Disclosure: No positions